Transfer pricing documentation for the small and mid-size company.

Background

The IRS's powers have steadily increased since Sec. 482 was amended by the Tax Reform Act of 1986. The changes made to Sec. 482 and the regulations thereunder have given the Service greater power to recharacterize transactions between related parties involving the transfer of tangible goods, services and intangibles.

Final Sec. 482 regulations issued on July 8, 1994 require taxpayers to gather documentation that supports the transfer prices used in their related-party transactions of both tangible and intangible property prior to the transactions, rather than years later during an IRS exam. Although the transfer pricing provisions apply to all taxpayers regardless of size, the documentation burden will fall especially hard on the small and mid-size companies that are also required to comply. However, many of the small or mid-size companies cannot afford the help of an outside consultant to assist them in the gathering of the documentation to defend against the assessment of penalties for noncompliance. Although a safe harbor exception is available for "small" taxpayers, very few companies will meet the eligibility tests. This leaves the small and mid-size companies scrambling to comply in a costefficient manner.

To force taxpayers to comply with the documentation requirements, Congress has added legislation providing authority and penalties to enforce these requirements (Secs. 6038A and 6662).

Required documentation

Taxpayers must choose and document the "best method," the one that provides the most accurate arm's-length result. Therefore, small and mid-size companies must select a specified method (detailed by the regulations) or unspecified method (unique method) and justify the selection.

Temp. Regs. Sec. 1.6662-6T(d)(2)(iii) requires that two types of documents must be maintained--principal documents and background documents. The regulations specifically require nine types of principal documents, which should describe in a complete and accurate manner the basic transfer pricing analysis conducted by the taxpayer to support the transfer pricing method used.

1. An overview of the taxpayer's business. This should include a narrative description of the company's history, product(s) produced, and explanations of specific factors or conditions that may have contributed to positive or negative financial results.

2. A description of the taxpayer's organizational structure. This should include organizational charts, personnel lists of the decision-makers and any other documentation that may assist an IRS agent (such as departmental charts).

3. Documentation explicitly required. This would include documentation regarding a cost-sharing arrangement if one existed.

4. A description of the method selected and why. Regulations under Sec. 482 strongly urge (but do not require) taxpayers to use one of five specified methods to support an arm's-length transfer price.

* The comparable uncontrolled price (CUP) method, which would determine the arm's-length price as the price paid in a closely similar case in which one or more parties are unrelated to the taxpayer's corporate group.

* The resale price method, which computes an arm's-length price by subtracting the appropriate gross profit from the price for which the goods are resold to an unrelated buyer.

* The cost plus method, which computes an arm's-length price as equivalent to the controlled party's cost of producing the goods plus an appropriate gross profit markup.

* The comparable profits method (CPM), which measures the total return of the taxpayer's business activities and compares these amounts to those of comparable companies.

* The profit split method, which determines whether transactions are arm's length by reference to what the taxpayer contributes to the combined operating profit or loss of the worldwide organization.

The regulations also provide for use of a hybrid method if that is indeed the "best method."

5. A description of specified methods considered and why they were not selected. This would include explanations such as no CUP existed to allow use of that method, or that the taxpayer is a distributor making the cost plus method a less likely "best method."

6. A description of controlled transactions. This information should agree with the taxpayer's financial statements and Form 5472, Information Return of a Foreign Owned Corporation, or Form 5471, Schedule M, Foreign Corporation Controlled by a United States Person, whichever is applicable.

7. A description of the comparable companies used to support an arm's-length transfer price and any adjustments made. This should include an overview of why certain companies were selected and why others were not. Financial statements of the comparable companies should also be provided as additional documentation and to support the analysis performed in #8 below.

8. An explanation of the economic analysis and projections relied on to determine the best method. This should include a description of the functional analysis performed to determine who (buyer or seller) is doing what in the transaction, who is assuming various risks involved in the transaction and who owns the intangible assets involved in the transaction. Additional documentation that should also be provided includes ratio analysis to support or refute the CPM. This should specifically include calculation of the following ratios: gross profit to operating expenses; operating profit to sale; and operating profit to operating assets. These ratios are provided for in Regs. Sec. 1.482-5(b)(4).

9. A general index of documents and a description of the taxpayer's recordkeeping system. This should include an address of the location of the records and who has physical custody of the records.

Background documents support the assumptions, conclusions or positions contained in the principal documents.

If a return for a particular year is selected for examination by the IRS, the taxpayer must establish that it prepared the documentation as of the time of filing its original tax return for the year in question. This documentation is also required to be provided to the Service within 30 days of request on audit.

Penalties

Although some taxpayers are risking noncompliance of these provisions, the penalties can be extreme for both those with the tax responsibility and the businesses involved. The regulations provide a 20% substantial valuation penalty and a 40% gross valuation penalty. The threshold for the 20% and 40% penalties are based on a percentage test (the amount by which the transfer price determined to be correct exceeds what was actually used), a dollar test (of the net Sec. 482 adjustment) and a gross receipts test (percentage by which the net Sec. 482 adjustment exceeds the taxpayer's gross receipts). Relief from these penalties is available if the taxpayer can show that it used a specified method, or (in limited circumstances) an unspecified method and that such method was applied reasonably and contemporaneous documentation was prepared prior to filing the tax return.

Conclusion

The documentation requirement, no matter how unreasonable it may seem, must be taken seriously by all taxpayers affected by this provision, regardless of size. Because of the large amount of documentation and the substantial penalties involved, small and medium-size taxpayers need to be assertive and accumulate the required documentation before the IRS comes calling.

From Mark E. Kral, Charlotte, N.C.